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No "re-classification“ of royalty payments into business profits under a tax treaty pursuant to Sec. 50D X S. 1 Income Tax Act (ITA)

In a recent ruling, dated 9 September 2010 (I R 74/09), the Federal Fiscal Court (Bundesfinanzhof) decided (again) on the tax treatment of so-called special payments (Sondervergütungen pursuant to Sec. 15 (1) s. 1 No. 2 ITA) by a German partnership to a US resident partner under the applicable double tax treaty (DTT). The ruling of the Federal Fiscal Court is of great relevance for all special payments to partners of a partnership if the applicable DDT does not provide for any specific provisions with respect to special payments. Such specific provisions are the exceptional case in German DDTs, e.g. the German DDTs with Austria, respectively Switzerland provide for specific provisions. The ruling was based on the following (simplified) facts of the case:

Limited partner of a German LP was — inter alia — an Inc. residing in the US (US-Inc.). The US-Inc. granted to the German LP — in exchange for a royalty payment — the right to merchandise and distribute its products as well as to use the trade mark and trade name of the US-Inc. The licenses have been administrated by the US-Inc. in the US.

The German tax office concluded that the royalty payments made by a domestic LP to its non-resident limited partner would have to be qualified as special payments pursuant to Sec. 15 (1) s. 1 No. 2 ITA and would have to be attributed to the German permanent establishment of the US-Inc. Consequently, the right of taxation of such special payments would — deviating from article 12 (1) DTT Germany USA 1989 — be with Germany (article 7 (1) DTT Germany USA 1989) rather than the US.

The Federal Fiscal Court held that royalty payments pursuant to article 12 (1) DTT Germany USA 1989 may solely be subject to tax in the US. The Federal Fiscal Court confirmed his previous jurisprudence (Federal Fiscal Court ruling dated 17 October 2007, I R 5/06 interest payments (cf. TaxInfo No. 008, July 2008, p. 16), according to which the right of taxation of special payments (here: royalty payments) is — pursuant to article 7 (6) DTT Germany US 1989 — generally with the state of residence (here: US).

According to the Federal Fiscal Court, the right of taxation may not be established on grounds of the exception for permanent establishments pursuant to article 12 (3) DTT Germany US 1989. This would require the license to be functionally connected to a permanent establishment in Germany, i.e. to qualify as an active business asset of the permanent establishment. According to the Federal Fiscal Court, the licenses may not be attributed to the German permanent establishment in the case at hand as the licenses have been administrated by the US-Inc. in the US. Irrespective of any legal attribution pursuant to Sec. 15 (1) s. 1 No. 2 ITA, it is only the functional connection which is decisive in determining the attribution of assets.

Contrary to the position of the tax authorities (see Federal Ministry of Finance circular dated 16 April 2010 regarding the application of Double Tax Treaties to partnerships, (cf. TaxInfo No. 011, September 2010) the Federal Fiscal Court takes the view that Sec. 50d (10) s. 1 ITA does not grant a right of taxation of the special payments to Germany. This provision has been introduced with retroactive effect by the Annual ABSTax Act 2009 as consequence of the jurisprudence of the Federal Fiscal Court (see above Federal Fiscal Court ruling dated 17 October 2007). The provision aims to overturn such Federal Fiscal Court jurisprudence by way of a so-called Treaty Override by re-classifying special payments into business profits for DTT purposes, provided that the applicable DTT does not provide for any specific provision with respect to special payments.

According to the Federal Fiscal Court, the unilateral re-classification of special payments into business profits for DTT purposes under Sec. 50d (10) s. 1 ITA has no scope of application in the given case: The fiction pursuant to Sec. 50d (10) s. 1 ITA stipulates a certain type of income for DTT purposes, i.e. business profits, however, such fiction does not release from the requirement of an existing permanent establishment and the attribution of such type of income to the permanent establishment. Rather, the general requirements for the attribution remain applicable. Such general requirements are to be determined in accordance with the applicable DTT — independently from any attribution under domestic German tax law pursuant to Sec. 15 (1) s. 1 No. 2 ITA — on a standalone basis. As the licenses have been administrated by the US-Inc in the US head office, such licenses may not be attributed to the German permanent establishment and are consequently not subject to German tax.

The BFH did expressly not decide (i) whether the retroactive application of Sec. 50d (10) s. 1 ITA could be a violation of the principle of due process and (ii) if and to what extent a Treaty Override complies with international and constitutional law.

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